Rational expectations is an economic hypothesis that suggests people’s expectations of future outcomes heavily influence current outcomes. It assumes individuals learn and adapt quickly to economic situations, and their actions shape the outcome. The theory also considers the general public as important economic agents.
“Rational expectations” is the name of a hypothesis in economics which states that an outcome is highly dependent on what people expect to happen in the future. People’s expectations are fueled by previous economic situations and available and relevant information. This economic hypothesis also considers the general public as an important economic agent, as opposed to considering only the government and its policies as the main actors in changing economic outcomes.
John Muth conceptualized the concept of rational expectations in 1961, when he wrote an article entitled “Rational Expectations and the Theory of Price Movements”. The economic hypothesis was Muth’s counter-response to a contemporary concept called adaptive expectations. The common ground for both theories is that people adapt to change and learn from experience, but adaptive expectations claim that people adapt gradually after a certain situation, in contrast to the idea of rational expectations that people have the ability to quickly learn and simultaneously adapt to economic situations as they are unfolding. Muth’s hypothesis later gained prominence after other economists such as Robert Lucas Jr., Edward Prescott, and Neil Wallace made use of it.
In rational expectations, the two elements, result and expectation, feed and influence each other. What people expect to happen will be the driving force behind their future actions, which will in turn shape the outcome. The current outcome, on the other hand, will create a new expectation and the cycle will continue. In exchange rates, for example, if people expect a certain currency to depreciate, it will cause them to withdraw their investments, causing that currency to decrease in value.
On a larger scale, one individual’s expectations can also influence another’s expectations, triggering a collective expectation for a situation. This increases the likelihood that an expectation will come true. In this way, rational expectations assume that a given economic outcome does not differ significantly from what people expect it to happen, making the theory an expectation consistent with the model. This belief applies to applied mathematics, particularly game theory, whereby a person relies on anticipating the choices of others to succeed in any situation that requires strategy.
Based on the term itself, rational expectation also assumes that people act in ways that make the best use of their resources and profits. Another theory is called rational choice theory. Apply this presumption by stating that people typically make choices to increase their profits while reducing costs.
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